September 12th, 2016

Managing Volatility Key To Solvency II Transition - GC@MC Commentary

Posted at 12:00 AM ET

paire-eric-smEric Paire, Head of Global Partners & Strategic Advisory, EMEA

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Movement Within Capital Ratios Leading to Uncertainty Amongst Mid-Size Companies

The impact of the Solvency II capital ratio on composite life and property/casualty balance sheets is proving more substantial than some companies initially expected, according to Eric Paire, Head of Global Partners & Strategic Advisory, EMEA at Guy Carpenter. This development is due to the double impact of market volatility and volatility within the solvency ratio itself.

According to Mr. Paire: “As companies shift from the preparation phase of their Solvency II strategy which focused on implementing the necessary processes and systems to the data crunching phase, they are gaining a much clearer picture of the potential capital charges - and in some cases, the results have been unexpected.”

“The life side of the balance sheet brings a very significant amount of market risk and in addition to the Solvency II capital pressures, there is also increasing capital solvency ratio instability. As a result, there are major fluctuations that many did not foresee on the solvency ratio linked to the asset side, as well as the impact of interest rate movements.”

Mr. Paire continues: “We are transitioning from a Solvency I era where the capital ratio was relatively stable subject to the ability to manage volatility within a P&L; to a Solvency II era which requires management of P&L volatility as well as solvency ratio volatility.”

The knock-on effect is increased uncertainty regarding the optimal capital level, according to Mr. Paire. Whilst a number of large-scale market players are targeting capital levels of 200 percent or above, for the mid-sized practitioners setting the solvency marker is a much greater challenge.

“To remain competitive, smaller companies simply cannot afford to operate at 200 percent. This volatility on multiple fronts means that establishing the solvency level that will provide a sufficiently robust capital buffer to withstand these fluctuations is extremely difficult. Is it 130 percent, 150 percent, 170 percent or higher?”

Mr. Paire believes that reducing this uncertainty requires companies to adopt a much more systematic risk management strategy, which combines both the asset and underwriting side of the operation and the life and non-life activities. “However, this more holistic approach will not be straightforward, as for many, these activities are conducted very much on a standalone basis.”

As a result, a greater onus rests on the broker to bring together these critical components. “We must be in a position to facilitate a much broader dialogue that covers all of the elements of the Solvency II equation,” Mr. Paire explains. “For Guy Carpenter, this entails bringing our life and non-life specialists to the table as well as working closely with our colleagues at Mercer to ensure that discussions cover underwriting and asset management.”

Managing the solvency ratio with the minimal amount of capital also requires companies to take full advantage of multiple tools, with reinsurance being one of the most effective mechanisms available. Mr. Paire asserts that “reinsurance is a much more attractive option than equity in the current market. Not only are rates low at present, but reinsurance also offers a significant degree of flexibility, which is critical given the high level of short-term volatility we expect to see as companies get to grips with their solvency requirements. Reinsurance is a dynamic solution, one that can be recalibrated quickly to match changing capital needs.”

He concludes: “If we were entering the Solvency II regime at a time of high interest rates and stable capital markets, the transition would be much more seamless; but we are not. We are facing turbulent conditions and companies must chart their solvency course carefully if they are to navigate them successfully.”

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